'Bulk' credit downgrades point to a treacherous road ahead for Europe

Standard & Poor's "bulk" downgrade of European nations and the eurozone bailout funds highlight more starkly than ever the continent's intractable problems.

Following a review, S&P has downgraded France and Austria from AAA to AA+. The other rating agencies may follow and the risk of further downgrades exists. The European bailout fund was downgraded last night, because of the loss of AAA ratings by France and Austria. This weakens its already compromised ability to raise funds to meet existing commitments to Greece, Ireland and Portugal and support the funding of other countries.

Over the next few months, the eurozone faces several challenges including the implementation of new arrangements, refinancing maturing debt and meeting required economic targets. Against this cataclysmic backdrop, it's a good time to take stock of the intractable problems facing Angela Merkel, Nicolas Sarkozy and the European Central Bank's Mario Draghi.

The Wall of debtEuropean sovereigns and banks need to find 1.9 trillion to refinance maturing debt in 2012. Italy alone requires 113 billion in the first quarter and around 300 billion over the full year.

Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this debt is uncertain. The bailout fund and the International Monetary Fund, with around 200 billion to 250 billion each, cannot absorb this issuance.

The only solution - "Sarko-nomics" - is for European banks to purchase the sovereign debt, which is then pledged as collateral to borrow unlimited funds from the ECB or national central banks. This perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government.

Looming recessionEurope's real economy is moribund, in danger of slipping into recession.

For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit and debt level targets will be missed.

In Ireland, the much-lauded poster child of bailout austerity, third-quarter GDP fell 1.9% and its gross national product declined by 2.2%. Spain may already be in recession. The budget deficit is above forecast (8% versus the 6% target agreed with the European Union) and the need for support of the Spanish banking system may strain public finances further. Unemployment is over 21% (nearly 5 million people).

Italy is forecasting a recession in 2012. While budget measures to stabilise debt have been passed, they focus on increasing taxes rather than cutting the country's expenditures. Structural reforms to promote growth are still under consideration and the content and timing is unknown. The plans may not be fully implemented or work.

Stronger countries within the euro-zone are also affected. German export orders are slowing, reflecting the fact that its sales to Italy and Spain totalled around 9-10% in 2010, higher than to either the US (6-7%) or China (4-5%). Lack of demand for exports within Europe and from emerging markets, combined with tighter credit conditions, may slow growth.

Political turmoilThe risks of political and social instability remain elevated. Greece faces elections in April 2011. The French presidential elections, scheduled for May 2012, also create uncertainty.

The two principal opponents to incumbent Nicolas Sarkozy either oppose the euro and the bailout (the National Front led by Marine Le Pen), or want to renegotiate the plan with the introduction of jointly guaranteed eurozone bonds (the Socialists under François Holland).

The European debt crisis is also creating political problems in Germany, The Netherlands and Finland, especially among governing coalitions.

A downgrade of Germany's cherished AAA rating, losses or any steps to undermine the sanctity of a hard currency (either by printing money or other monetary techniques) will focus attention on the costs to its citizens of the bailouts.

The German commitment to date is 211 billion in guarantees, 45 billion in advances to the IMF and 500 billion owed to the Bundesbank by other national central banks - around 25% of German's GDP.

European roads, especially German autobahns, are known for their excellence. In marked contrast, Europe's economic and financial road ahead resembles the pot-holed, crumbling and treacherous stradas of emerging countries. It is likely to take the skills and experience of a champion rally driver to successfully negotiate this difficult route.

Given the skills demonstrated to date by European leaders, it is doubtful whether the course will be completed without a crash or two.

The only real question is about the extent of the damage - both direct and collateral.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)